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Forfeiture of assets on insolvency: “it’s yours until you go bust”

The Supreme Court has clarified the extent to which it is possible for a contract to provide for a company or individual to lose assets on insolvency.

Summary

Well-established rules are unchanged, so landlords can still forfeit leases on insolvency. In other cases, if a transaction is entered into in good faith and for valid commercial reasons, it is likely to be upheld.

Office-holders challenging transactions will have to find evidence of bad faith or an attempt to evade insolvency legislation.

The anti-deprivation rule

There is a well-established rule, dating back more than 200 years, which says that attempts to remove property from an insolvent person’s estate are invalid:

“A simple stipulation that, upon a man’s becoming bankrupt, that which was his property up to the date of the bankruptcy should go over to some one else and be taken away from his creditors, is void as being a violation of the policy of the bankruptcy law.” (Ex parte Jay (1880) 14 Ch D 19, 25)

Good faith and commercial arrangements

The Supreme Court decided that the anti-deprivation rule should not apply where the parties act in good faith and for sound commercial reasons. In borderline cases a commercially sensible transaction entered into in good faith will not be held to infringe the rule.

The Supreme Court stopped short of saying that good faith will always be a defence, but office-holders are unlikely to want to risk challenging a transaction which has a real commercial justification.

Deprivation for reasons other than insolvency

The anti-deprivation rule does not apply where the deprivation takes place for reasons other than the insolvency of the owner of the property. For example, where the event of default is the insolvency of a parent company or another member of the group, the rule will not be infringed.

Temporary interests, “flawed assets” and leases

The rule as set out above is difficult to reconcile with the well-established principle that a lease can contain provisions that it is to end if the tenant becomes insolvent. The law distinguishes between the loss of an asset on insolvency (which infringes the rule) and ownership for a limited time, which does not. The Supreme Court accepted that this distinction was extremely hard to justify or explain, but it is too well-established to be changed.

The practical significance of the Supreme Court’s decision is that the law will continue to recognise the validity of forfeiture provisions in leases, and analogous provisions in similar documents. A transaction which is designed to remove an asset from an insolvent estate in other situations without commercial justification will be vulnerable to challenge - the court will look at the substance, not the form.

Contrast with equal distribution rules

Earlier cases had confused the anti-deprivation rule with the rule on equal treatment of creditors (or the “pari passu” rule). They are not the same. A transaction which removes assets from the estate will be valid if it is commercially justifiable and in good faith. A transaction which purports to give creditors a right to more than their pro-rata share will always be invalid.

The practical significance of the case:

Office holders now know that they need to focus on whether or not a transaction is in good faith. This will usually involve looking at the reasons for it, and not just at what the documentation says.

Anyone entering into an unusual transaction which might deprive the other side of property or rights on insolvency needs to document the reasons for this at the time, as this will provide the best defence to any challenge.

Failing to document the reasons makes the transaction more vulnerable.

There is no change to established situations such as leases or licences which terminate on insolvency.